Risk Based Capital (Basel II) for Banks in Bangladesh: A straightforward Journey
Abu Hena Mohd. Razee Hassan
K. M Abdul Wadood

Abstract
Banks operating in Bangladesh are much enthusiastic for maintaining risk based capital in line with Basel II. Self audit report 2008 on compliance with Basel Core Principles (BCPs) shows, Operational independence of Bangladesh Bank, supervisory tools, existing prudential regulations for core risk management as introduced in banking industry by BB has developed an environment is favorable for implementing Basel II. Bangladesh Bank (BB) has commenced the implementation of Basel II from January 2009 and has provided banks guideline for computing Minimum Capital requirement (MCR) on the basis of Risk Weighted Assets (RWA). The techniques of calculation of RWA will follow Standardized Approach for Credit Risk, Standardized (Rule Based) Approach for Market Risk and Basic Indicator Approach for Operational Risk. In Standardized Approach risk weight of exposures will be differentiated based on external credit assessments and the risk weights will be inversely related to the credit rating of the counter party. Calculation of RWA under Standardized Approach is supported by External Credit Assessment Institute (ECAI). The recognition process of BB will ensure ECAIs eligibility criteria as required by the Basel II document. In addition to computing MCR banks have to calculate adequate capital with the procedure as stated in the section second pillar or Supervisory Review Process (SRP) of Basel II. Calculation of adequate capital and preparation of a process document in this regard is an enormous job for the banks. The areas to be covered by the process document are review of risk management and planning for adequate capital against comprehensive risk profile including credit, market and operational risk. Roadmap on Basel II implementation in Bangladesh sates that bank will progressively move towards Internal Rating Based (IRB) approach for calculating RWA from the year 2012. So, it is another great task for banks as well as Bangladesh Bank.

Key Words: Risk based Capital Adequacy, Minimum Capital Requirements, Standardized Approach, Internal Rating Based Approach, Credit Risk, market Risk, Operational Risk, Supervisory Review Process

The author of this report, Abu Hena Mohd. Razee Hassan is the General manager at the banking Regulation and Policy Department and K.M. Abdul Wadood is the Deputy General Manager of Basel II Implentation Cell, Banking Regulation and Policy Department, Bangladesh Bank.
Introduction
Implementation of risk based capital in line with Basel II is a challenge for many developing countries including Bangladesh. However, the Basel Committee on Banking Supervision has released a substantial number of documents on banking supervision those are contributing to enhance competitive equality among the banks throughout the world. On June 26, 2004, the Basel Committee on Banking Supervision (BCBS) released the document "International Convergence of Capital Measurement and Capital Standards: A Revised Framework", which was supplemented in November 2005 by an update of the Market Risk Amendment. This document, popularly known as "Basel II Framework", offers a new set of international standards for establishing minimum capital requirements for the banking organizations. It capitalizes on the modern risk management techniques and seeks to establish a more risk-responsive linkage between the banks' operations and their capital requirements. It also provides a strong incentive to banks for improving their risk management systems. The risk sensitiveness is achieved through the three mutually reinforcing Pillars. The basic goal of Basel II is to make it more risk-sensitive so that financial institutions will be more shock absorbent and able to sustain even in periods of financial crisis. Pillar 1 set out the minimum capital requirements for a bank’s operational risk, in addition to credit risk and market risk. Pillar 2 requires that banks should have in place sound internal processes to assess the adequacy of their capital, based on a thorough evaluation of their risks including those risks not covered under Pillar 1, and that both supervisors (bank’s own & regulator) should carry out “supervisory review” of this process. Pillar 3 is to complement Pillars 1 and 2 through enhanced market transparency and market discipline by requiring banks to make public disclosure of information on their risk profiles, capital adequacy and risk management. With a view for ensuring transition to Basel II in a non-disruptive manner, BB has adopted a consultative approach. In this process, a high-level National Steering Committee (NSC) has been formed comprising central bank and commercial banks’ officials for the policy decision. Furthermore, there is a Coordination Committee to assist the NSC in decision-making and an Implementation Cell at BRPD to assist it and carry out the instructions of NSC and Coordination Committee. Before drawing the Roadmap on Basel II implementation, BB and Coordination Committee carried out two sorts of study, i.e. (i) Self Audit on BCP compliance; and (ii) Quantitative Impact Study (QIS) to assess preparedness of Banks.

(i) Self Audit on BCP compliance: The Basel Core Principles (BCPs) for effective banking supervision are a set of principles supported by lot of essential and additional criteria formulated by Basel Committee on Banking Supervision (BCBS) for assessing standards of supervisory practice. Implementation of the core principles is necessary for improving financial stability and provides a basis for development of effective supervisory systems.

(a) In Bangladesh in 2002, IMF and World Bank jointly carried out an audit on BCPs and found status of 1 compliant and 4 largely compliant principle out of 25 principles. Based on their report BB and Government took many remedial measures. A self-audit on the compliance of BCPs further conducted by a self audit team of BB in 2006 (revised in 2008). It shows BB’s supervisory mechanism comprises minimum and favorable standards for implementing Basel II in banking industry. BB has fully complied with 7 principles and largely complied with 14 principles out of 25 BCPs. (b) In 2002, Money Laundering Prevention Act (MLPA) 2002 is enacted. BB has made ‘Know Your Customer’ (KYC) mandatory, for proper compliance of the provisions of the MPLA 2002, for all banks and financial institutions and instructed them to preserve correct and full information of their customers and keep record and to report to BB if any unusual or suspicious transaction is detect.

(c) In 2003, five separate guidelines on five core risks such as credit risks, asset and liability/balance sheet risks, foreign exchange risks, internal control and compliance risks and money laundering risks were issued. (d) In 2004, BB adopted Credit Risk Grading (CRG) system by replacing Lending Risk Analysis (LRA), which is playing a crucial role of assessing borrower, mitigation risk, and determining risk premium at the pre-sanction stage of credit allocation. The system is associated with on going review process for observing transition toward default status of the borrowers. For computing RWA on the basis of Internal Rating Bases Approach (IRBA) under Basel II such CRG data is an initial foundation. (e) In 2005, it issued another separate guideline on Information and Communication Technology. The guidelines were minimum instructions for the banks and were asked to build up their own risk management manuals.

(f) Since 2006 existing CAMEL has been replaced by CAMELS for assessing performance of Banks & Non Bank Financial Institutions (NBFIs), which covers ratio analysis on Capital Adequacy, Asset Quality, Management Efficiency, Earnings, Liquidity and Sensitivity to market along with 38 questions for qualitative judgments.

(g) A Financial Intelligence Unit has set up at BB to detect and investigate financial crime in the banking system of Bangladesh. (h) Early Warning System (EWS) and Problem Bank Monitoring Cell have been established for close observation of financial indicators of banks with weak performance and aware them to improve their performance. ii) QIS to assess preparedness of Banks:
BB has carried out a Quantitative Impact Study (QIS) in April-May 2007 to assess the preparedness for implementing Basel II and bank’s view on the optional approaches for calculating Minimum Capital Requirement (MCR). QIS revels that the banks are Basel I compliant and quite aware of core risk management and much willing to implement Basel II but highly emphasized on capacity building of the officials of central banks and commercial banks those would be work with Basel II implementation, Supervision and Risk Management. Further the study shows that under the Credit Rating Companies Rules, 1996 practiced by Securities and Exchange Commission (SEC) of Bangladesh two credit rating agencies have been registered and operating in Bangladesh for several years.

Introduction of Risk based capital adequacy : A review

Since 1996 BB has been introduced a new approach for assessing the regulatory capital adequacy based on Risk-weighted Assets (RWA) replacing Capital-to-Liability approach with a view to mitigate losses arisen out of banking activities. The revised policy on capital adequacy takes account of different degrees of credit risk and covers both on-balance sheet and off-balance sheet transactions. Bangladesh is following Basel-I for banks capital adequacy requirement and maintaining a minimum Capital Adequacy Ratio (CAR) not less than 10 % of their RWA or 4 billion BDT which one is higher. Core capital (Tier-1) should not be less than 5% of RWA. Minimum Paid up Capital/Capital deposited with BB (applicable for foreign bank branches) to be maintained at the level as fixed by BB from time to time. CAR would be derived dividing total Adjusted Capital by RWA and multiplied by 100.

| |Adjusted Capital | | |
|CAR = | |×100 | |
| |RWA | | |

As per current regulation (Basel I) RWA is calculated against credit risk only. As per ‘Risk Based Capital Adequacy for Banks’ as introduced from January 01, 2009 parallel to current regulation, RWA will cover market and operational risk along with credit risk.

Regulatory Capital Comprises of
a) Core Capital (Tier-1) – Paid up Capital – Non-repayable Share premium account – Statutory Reserve – General Reserve – Retained Earnings – Minority interest in Subsidiaries – Non-Cumulative irredeemable Preferences shares – Dividend Equalization Account
b) Supplementary Capital (Tier-2) – General Provision – Assets Revaluation Reserves – All other preference shares – Perpetual Subordinate debt – Exchange Equalization A/C

Mechanism of Calculation of RWA under existing regulation (Basel- I)
|Assets in the Balance Sheet and Off Balance |Risk Weight |Risk Weighted Assets |
|Sheet | | |
|A |0% |A×0% |
|B |20% |B×20% |
|C |50% |C×50% |
|D |100% |D×100% |
|Total Risk Weighted Assets (RWA) = |xxxxxx |

Calculation of Adjusted Capital under existing regulation (Basel- I)
a) Core Capital(Tier-1) ---------- – Less Shortfall in provision (-) ---------- – Less other (If any) (-) --------- b) Adjusted Core Capital : --------- c) Supplementary Capital(Tier-2) ----------
d) Adjusted Capital = (b + c) -----------
Structure of Basel II
Range of options for computing Risk Weighted Asset (RWA)
|1. Minimum Capital Requirement (Pillar-1) | |
| |Capital for Credit Risk | |
| |Standardized Approach | |
| |Simplified Approach | |
| |Comprehensive Approach | |
| |Internal Rating Based (IRB) Foundation Approach | |
| |Internal Rating Based (IRB) Foundation Approach | |
| |Capital for Market Risk | |
| |Standardized Rule Based Approach | |
| |Maturity Method | |
| |Duration Method | |
| |Internal Model (VaR) Approach | |
| |Capital for Operational Risk | |
| |Basic Indicator Approach | |
| |Standardized Approach | |
| |Advanced Measurement Approach | |
|2. Supervisory Review Process (Pillar-2) | |
| |Evaluate Risk Management by an exclusive review team | |
| |Review comprehensive risk profile | |
| |Ensure maintenance of adequate capital | |
| |Develop an internal process document for review risk and planning for adequate capital | |
| |Risk based inspection to ensure risk management and adequate capital | |
|3. Market Discipline (Pillar-3) | |
| |Enhance Disclosure to attract stake holder’s confidence | |
| |Core & Supplementary Disclosures | |
| |Timely & perfect disclosures | |

Banks options for computing RWA under Basel II in Bangladesh
The QIS findings suggested for initial Basel II implementation with the following specific approaches: a) Standardized Approach for calculating Risk Weighted Assets (RWA) against Credit Risk; b) Standardized (Rule Based) Approach for calculating RWA against Market Risk; and c) Basic Indicator Approach for calculating RWA against Operational Risk . Accordingly a revised regulatory framework for banks for Basel II implementation has been devised named “Risk Based Capital Adequacy for Banks” available at BB website www.bangladeshbank.org.bd. Total Risk Weighted Assets (RWA) will be determined by multiplying capital charge for market risk and operational risk by 10 (i.e. the reciprocal of the minimum capital adequacy ratio of 10%) and adding the resulting figures to the sum of risk weighted assets for credit risk i.e. Total RWA = RWA for Credit Risk + 10 × (Capital Charge for Market Risk + Capital Charge for Operational Risk). Minimum Capital Requirement (MCR) would be 10% of Total RWA which will cover minimum Paid up Capital/Capital deposited with BB (applicable for foreign bank branches) as fixed by BB from time to time. Total Eligible Regulatory Capital would be Eligible tier1 Capital + Eligible tier2 Capital + tier3 Capital. Definition of Tier I and Tier2 capital will remain same as stated in existing rule. Tier-3 capital is a provision to include short term subordinate debt if any. In order to obtain the Eligible Regulatory Capital for the purpose of calculating Minimum Capital Requirements (MCR), banks are required to make following deductions from their Tier-1 capital; i) Book value of goodwill; ii) Shortfall in provisions required against classified assets; and iii) Remaining deficit on account of revaluation of investments in securities after netting off from any other surplus on the securities. Eligible tier-2 capital will be derived after deducting components if any qualified for deduction.

a) Standardized Approach for calculating RWA against Credit Risk:
In this approach credit exposures will be differentiated based on external credit assessments. The risk weights are inversely related to the rating of the counter party. BB has stipulated the following risk weight system for calculating RWA against credit risks in banking book.

|Sl. |Exposure Type |BB’s Rating Grade |Risk Weight |
| | | |(%) |
|a. |Cash and Cash Equivalents | |0 |
|b. |Claims on Bangladesh Government (other than PSEs) and BB | |0 |
|c. |Claims on other Sovereigns & Central Banks |
| |[Banks may use the rating & risk weight as recognized by their home supervisors(if any) or risk-scores published by the |
| |consensus risk scores of ECAs participating in the “Arrangement on Officially Supported Export Credits”. These scores are |
| |available on the OECD’s website (http://www.oecd.org)]. |
|d |Claims on Bank for International Settlements, International Monetary Fund and | |0 |
| |European Central Bank | | |
|e |Claims on Multilateral Development Banks (MDBs) | |
| | i) IBRD , IFC, ADB, AfDB, EBRD, IADB, EIB, | |0 |
| |EIF, NIB, CDB, IDB, CEDB | | |
| | ii) Other MDBs |1 |20 |
| | |2,3 |50 |
| | |4,5 |100 |
| | |6 |150 |
| | |Unrated |50 |

Continued to next page
|Sl. |Exposure Type |Risk Weight |
| | |(%) |
|f |Claims on Public Sector Entities (other than Government) in Bangladesh |1 |20 |
| | |2,3 |50 |
| | |4,5 |100 |
| | |6 |150 |
| | |Unrated |50 |
|g |Claims on Banks & NBFIs : | |
| |i) Maturity over 3 months |1 |20 |
| | |2,3 |50 |
| | |4,5 |100 |
| | |6 |150 |
| | |Unrated |100 |
| |ii) Maturity less than 3 months | |20 |
|h |Claims on Corporate (excluding equity exposures) |1 |20 |
| | |2 |50 |
| | |3,4 |100 |
| | |5,6 |150 |
| | |Unrated |125 |
|Fixed Risk Weight Groups: | |
|i |Claims categorized as retail portfolio & Small Enterprise (excluding consumer finance ) |75 |
|j |Consumer Finance |100 |
|k |Claims fully secured by residential property |75 |
|l |Claims fully secured by commercial real estate |100 |
|m |Past Due Claims (Risk weights are to be assigned to the amount net of specific provision): | |
| |1. The claim (other than claims secured by eligible residential property) that is past due for more than| |
| |90 days and/or impaired will attract risk weight as follows: | |
| | - Where specific provisions are less than 20 per cent of the |150 |
| |outstanding amount of the past due claim ; | |
| | - Where specific provisions are no less than 20 per cent of the |100 |
| |outstanding amount of the past due claim. | |
| | - Where specific provisions are more than 50 per cent of the |50 |
| |outstanding amount of the past due claim. | |
| |2. Claims fully secured against residential property that are past due for more than 90 days and/or |100 |
| |impaired specific provision held there-against is less than 20% of outstanding amount | |
| |3. Loans and claims fully secured against residential property that are past due by 90 days and /or |75 |
| |impaired and specific provision held there-against is more than 20% of outstanding amount | |
|n |Investments in venture capital |150 |
|o |Investments in premises, plant and equipment and all other fixed assets |100 |
|p |Claims on all fixed assets under operating lease |100 |
|q |All other assets |100 |

Note: Unrated : Counterparty/Instruments those are not rated by any recognized ECAIs

ECAI’s various rating category will be mapped and published showing equivalency with that of BB rating grade while recognition process will be completed. BB rating grade is expressed in numerals 1 to 6, being 1 is the best.

A comparison of computing capital charge under Basel I and Basel II
Basel I:
A Tk. 100/- Crore corporate loan with a 1 credit rating would necessitate Tk.100 Crore x 100% x 10% = BDT 10 Crore capital charge.
A Tk. 100/- Crore corporate loan with a 5 credit rating would necessitate Tk. 100 Crore x 100% x 10% = BDT 10 Crore capital charge.
Basel II:
A Tk. 100/- Crore corporate loan with a 1 credit rating would necessitate Tk. 100 Crore x 20% x 10% = BDT 2 Crore capital charge.
A Tk. 100/- Crore corporate loan with a 5 credit rating would necessitate Tk. 100 Crore x 150% x 10% = BDT 15 Crore capital charge.
Capital requirements under Basel II should increase for banks that hold risky assets and decrease significantly for banks that hold lower risk.
Credit Risk Mitigation (CRM)
Under the technique of calculating RWA under Basel II banks will have some facility of reducing capital requirement under Credit Risk Mitigation (CRM) for receiving financial collateral or credible/eligible guarantee as security against their financing. Suppose a bank has financed Tk. 100/- crore to a corporate bearing credit rate 5. The bank has secured the loan receiving T&T Bond of Tk. 100 crore (residual maturity is more than one year). Here the bank will be allowed to apply net-off facility on the basis of following ‘haircut formula’ under CRM - E* = max [0, E x (1 + He) - C x (1 - Hc - Hfx)]
Where:
E* = the exposure value after risk mitigation E = current value of the exposure for which the collateral qualifies as a risk mitigate He = haircut weight appropriate to the exposure C = the current value of the collateral received Hc = haircut weight appropriate to the collateral Hfx = haircut weight appropriate for currency mismatch between the collateral and exposure
Thus the formula results net exposure
E* = 100×(1 + 0.12) – 100×(1 – 0.03) = 112 – 97 = 15 crore Tk.
So, this will necessitate capital charge 15 x 150% x 10% = Tk. 2.25 Crore.
Guarantee as CRM
Again assume example, A Tk. 100/- crore corporate loan with 5 credit rating which is secured by a guarantee provided by International Financial Corporation (IFC), this will necessitate Tk. 100 Crore x 0% = Tk. 0.00 Crore capital charge.
Past Due Loan
In case of classified loan banks will have capital reducing opportunity applying direct netting off the specific provision kept as cushion. Suppose a Tk. 100/- crore corporate loan secured by other than residential property , classified as bad/loss and has kept specific provision Tk. 30 crore will necessitate (Tk. 100 Crore -Tk. 30 crore) x 100% x 10%= Tk. 7.00 Crore capital charge as MCR. Here bank may keep some more funds (if necessary) for the sake of adequate capital on the basis of subjective analysis under banks own Supervisory Review Process (Ref. 2nd pillar of Basel II).

Capital Charge against Market Risk

Capital charge for market risk will be calculated on trading exposures of the banks. So, for calculating capital charge against market risk banks asset profile requires to be segregated between Banking Book exposure and Trading Book exposures. Banks assets related to trading activity inherent with risk of loss due to volatility of market variables like foreign exchange rate, interest rate and price. Volatility of these market variables relate to the quantity supply of and demand of the market for a particular instruments. So, for calculating capital charge Basel II states two sorts of risk and their weight to be considered under the Standardized (rule based) Approach i.e. a) Specific risk for supply side and b) General Market risk for demand side.
As per BB guideline the capital charge for market risks under standardized (rule based) approach include:
|Components |Specific Risk |General Market Risk |
|a) Risk pertaining to Interest Rate related | (BB has fixed the risk weight in tabular | (BB has fixed the risk weight by maturity, |
|securities in the trading book |form by nature of the issuer and by maturity)|by nature of the issuer and by estimated |
| | |yield) |
|b) Risk pertaining to equities in the trading|10% of market value |10% of market value |
|book | | |
|c)Foreign exchange risk throughout the bank |- |10% of over all net position |
|and | | |

Capital charge against Operational Risk
Operational Risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk.
b) Gross income: Gross Income (GI) is defined as “Net interest income” plus “net non-interest income”. It is intended that this measure should - (i) be gross of any provisions (ii) be gross of operating expenses, including fees paid to outsourcing service providers (iii) exclude realized profits/losses from the sale of securities held to maturity in the banking book. (iv) exclude extraordinary or irregular items as well as categorize (v) exclude income derived from insurance.
Gross income = Net profit (+) Provisions & contingencies (+) operating expenses (–) items (iii) to (v) above.
Minimum Vs Adequate Capital , Which one a bank will maintain under Basel II ?
According to Supervisory Review Process (2nd pillar of Basel II) a bank will maintain not only at minimum, they should have capital at adequate to meet comprehensive risk of losses relates to their assets and activities. Adequate capital means enough capital to compensate all the risks in their business, supported by a practice of better risk management techniques in monitoring and managing their risks. The adequate capital requirement will be some what more than minimum regulatory capital. At each bank level an exclusive Supervisory Review team will be responsible for preparing a process guideline for calculating adequate capital against comprehensive risk profile of the bank. Comprehensive risk means credit-market-operational risk plus some other risk underlying with bank assets but not captured under the process of calculating MCR.

Future challenges to overcome Automated Business Process and Management Information System could be a real blessing in the implementation process of Basel II. BB and banks are sharing their experience to build a strong IT infrastructure for a sound banking system. Banks operating in Bangladesh are presently practicing risk based banking and capable to identify, measure & mitigate core risks inherent in banking operation. Before switching over to the New Capital Accord (Basel II) finally, BB launched to implement the new capital accord with a parallel basis from January 2009, i.e., MCR under Basel I as per existing regulation and simultaneous calculation of MCR under Basel II, for at least one year and shall be made mandatory for compliance on subsequent years. However, review and monitoring of the proceeding and compliance has been started form January 01, 2009.

Roadmap of implementation of Basel II will follow the specific approaches as initial steps, popularly know as ‘Standardized Approach’ for calculating Risk Weighted Amount (RWA) against Credit Risk supported by ECAIs, ‘Standardized Rule Based Approach’ against Market Risk and ‘Basic Indicator Approach’ for Operational Risk. Banks are internaly practicing Credit Risk Grading of their counterpart since 2004 For calculating MCR under Foundation IRBA, bank will derive figure for determining Probability of Defaulted (PD) on the basis of own database; and seek figure on Loss Given to Default (LGD), Exposure at Default (EAD) & Maturity (M) of Credit Exposure from central bank. Central Bank will collect those CRG data and develop and maintain required loss database to meet the requirements by 2012. Under Advance IRBA, banks will derive all those components (LGD, EAD & M) along with PD on the basis of their own internal rating and loss database will run on continuous basis.

Concluding remarks BB has given utmost concentration and best possible effort through consultative approach for implementing Basel II. Based on self-assessment on BPCs for effective banking supervision and QIS the New Capital Accord (Basel II) has be been scheduled to be implemented in Bangladesh from the January 2009. As a measure of improving risk measurement in banks, BB has already introduced guidelines on managing core risk in banks. Those guidelines have created an environment conducive to development of risk management policies and practices of banks in Bangladesh. Therefore, implementation of those will ease the implementation of Basel II in Bangladesh. Though these guidelines have addressed the issue of operational risk management in a piece-meal manner, a comprehensive document in line with Basel Committee’s requirements is yet to be initiated. The exact nature of operational risks depends on the dynamics of the financial institute and its business environment. Individual banks will require identifying, assessing and monitoring the operational risks that they are exposed to. BB, as a supervisor, may produce a generic version of such a document and instructs the banks to develop their own guidelines following that version. Alternatively, the BB may instruct the banks to prepare and document their guidelines on supervisory review and managing operational risk in line with the above principles that are applicable to them. However, such initiation will be a sound footing for the banks to adopt Basel II and smooth transition to New Capital Accord.

References: International Convergence of Capital Measurement and capital Standard (BCBS June, 2006); Guidelines on Risk based Capital adequacy; Guidelines for recognition of eligible ECAIs; Articles on Capital Adequacy available on the websites